Video 7:14
China's growth wanes

Steve Johnson from Intelligent Investors reckons China's investment-led growth is waning, with major implications for the Australian economy

Transcript

TICKY FULLERTON, PRESENTER: A key reason the Reserve Bank cited for yesterday's rate cut was the slowdown in China.

Well today's figures out of China show a knock to the services sector, suggesting the Middle Kingdom's giant economy is slowing right across the board.

Maybe things will settle at a new normal of a less turbo-charged 7 or 6 per cent growth, but that could still have major implications for the Australian economy and not just the mining bit.

Well to explore this a little more I'm joined in the studio by Steve Johnson from The Intelligent Investor.

Steve, welcome.

STEVE JOHNSON, THE INTELLIGENT INVESTOR: Hi, Ticky.

TICKY FULLERTON: Let me start with figures here today. The worst monthly trade performance in four and a half years, over $2 billion in deficit, I think. Looks like much of that was driven by the China slowdown.

STEVE JOHNSON: Yes, it's surprising how quick that's flown through to the numbers. I would have expected it to take at least another six or seven months before we started seeing some drastically bad numbers here in Australia, just because there's so much supply coming on stream at the moment. But it's worryingly bad numbers on the trade side of things at the moment.

TICKY FULLERTON: I'm looking at - fall in export of metal, ores and minerals down 7 per cent by $464 million, coal down 11 per cent by $372 million. That's just for the month. They're big numbers.

STEVE JOHNSON: Yes, correct. And most of that is price driven, not volume driven, so we're exporting as much as we were, but the prices that we're getting for those things are down significantly on where they were just three months ago and particularly on where they were 12 months ago.

Iron ore, for example, we're getting $180 a tonne a year ago and that's trading down at $100 a tonne at the moment. So, very, very significant changes in the terms of trade.

TICKY FULLERTON: So when we hear about this key benchmark of the services sector in China showing a hit, we know that the manufacturing sector in China, I think, falling orders for 11 months now, how significant is that that it's gone across to the services sector?

STEVE JOHNSON: Well hopefully the services sector is the one part of the Chinese economy that really picks up because this move away from an export-dependent and an infrastructure-dependent economy is a very, very important one for China over the long term.

They're far, far too dependent on those two sectors. And the idea is that as the Chinese consumer gets richer, they're going to pick up the slack as the infrastructure spending comes off in China. That won't happen in the short term. It hopefully will happen over the longer term, but at the moment all those factors are working against it at once.

TICKY FULLERTON: So how sustainable do you think really the overall model of pumping investment into infrastructure, cheap exports, really can be in China?

STEVE JOHNSON: It's not sustainable at all. We're seeing all sorts of imbalances build up in the Chinese economy, particularly on the debt side of things and on banks' balance sheets and there's a lot of off-balance sheet funding going on in China as well.

The Chinese authorities know this though. They know it much better than the Australian authorities know it. They've been talking about it now for at least 12 months and they seem to be getting quite serious about managing the transition away from infrastructure.

TICKY FULLERTON: Yes, because when - we were talking about debt just now, but presumably some of that investment has gone into infrastructure where the economic value is not actually going to be greater than the investment put in so the debt's rising at that level too?

STEVE JOHNSON: That's correct. So when the world hit the skids, the world economy hit the skids back in 2009, China was very, very dependent on its exports and those exports took a hit.

What they did say was say, "Well we can stimulate our economy by building stuff." So they built roads, they built airports, they built train lines that propped up the GDP growth in the short term.

Now, in the long term what matters is whether that infrastructure generates an appropriate economic return or not, whether it generates enough return to cover the debt that's been used to build it. We're seeing signs that that's clearly not the case.

Now some of this stuff may take a long time to pay off, but there's been a lot of anecdotal evidence of misallocated resources in the Chinese economy.

TICKY FULLERTON: Where do you see long-term growth? Do you see it around consensus of sort of 5 to 7 per cent going forward?

STEVE JOHNSON: I think we'll see lower than that, particularly over the next four or five years. I think even the pessimistic people in the Chinese economy have got their estimates too high, and the reason is that that infrastructure component has grown from 35 per cent of China's GDP up to 50 per cent of its GDP.

So, even if consumption picks up the slack - it's now at 33 per cent of GDP - that part of the economy needs to grow twice as quick as the infrastructure part was growing just to compensate for that loss of growth there.

TICKY FULLERTON: Where does this leave iron ore prices now? Do you think there is a flaw?

STEVE JOHNSON: Well there's a flaw and that flaw will depend on the cost curve and where the demand is in future. There's a lot of - at the moment there's a lot of high cost Chinese production out there at around that $120 a tonne level. I think that will ...

TICKY FULLERTON: That's quite a high level, really, isn't it?

STEVE JOHNSON: That is a high level and that would be very, very good for Australia. There's two really important things there. Firstly the demand might be much, much less than people are expecting and that will mean a much lower point in the cost curve.

The second thing is that there's an assumption that the Chinese are going to be economically rational and shut down their iron ore production when the price falls below the marginal cost of producing it.

Now, we've already seen in the steel sector in China that jobs are far more important than profit. So they are keeping open loss-making steel-making ventures. The numbers are that there's 15 per cent too much steel production in China and yet they're still not shutting down capacity.

Now, I think we're a very good chance of seeing the same thing in the iron ore space as well, that they go on producing well beyond the point where it's no longer economically sensible to do so.

TICKY FULLERTON: So you're more bearish than consensus and you have been in past months, but you reckon there's been plenty of money to be made holding that position.

STEVE JOHNSON: Yes. We had a - those China bears like myself, we had a tough 12 months two years ago and the last 12 months have been very good to most of us. Our fund for example's up 35 per cent and there are other fund managers out there that didn't own resources and didn't own mining services that have done particularly well.

As interest rates have come off, that's really driving demand in the stock market for high-yielding safe stocks and we're doing very, very well in that space.

TICKY FULLERTON: As my father used to say to me, "Stick to one position, you'll eventually be right".

STEVE JOHNSON: That's exactly right.

TICKY FULLERTON: (Laughs) OK. Now, you feel the RBA as well now is getting pretty worried about this mismatch between the Australian dollar and commodity prices?

STEVE JOHNSON: Yes. The whole idea behind a floating exchange rate is that it acts as a pressure valve in your economy so that when something like the tremendous increase in terms of trade happens that's happened in Australia over the last decade, the exchange rate acts as an adjustment mechanism, so it goes up and that encourages people to allocate resources away from other sectors of the economy that are struggling because of the high exchange rate and towards the mining sector.

Now as those terms of trade come off, what we want is the exchange rate to come down so that those other sectors that have been struggling can step up and take up the slack where the mining sector's coming off.

Now we've seen the terms of trade come off and we haven't seen the exchange rate move at all really over the past six months. So, my guess is that the Reserve Bank is getting quite worried about that. The reason that the exchange rate is high is because there's a global game going on of who can get their exchange rate the lowest because no-one wants to have a high exchange rate.

So, everyone's got their interest rates low except Australia and that's causing a lot of money, a lot of foreign particularly central bank money to come into the country.

TICKY FULLERTON: And more on that next week at the finance meeting in Japan, I think.

STEVE JOHNSON: Yes.

TICKY FULLERTON: Steve Johnson, thank you very much for talking to us.